For market observers, it appears the spell of ultra-low volatility that had been cast over the global equity landscape during the past 12-18 months has been broken.
An escalation in trade tensions between the US and China is the chief catalyst for the most recent broad-based equity decline. Given the levels of uncertainty which the proposed tariff threats have introduced, the key question from an investment perspective is whether the conflict will remain relatively contained or intensify into a genuine and sustained conflict.
According to the Memorandum signed by President Trump on 22 March the United States Trade Representative (USTR) is proposing a 25% duty on ‘’at least US$50 billion’’ worth of Chinese exports including the aerospace, information and communication technology and machinery sectors. The detailed list of all products involved will be published by the USTR within 15 working days. Relative to market expectations of US$60bn, based on leaked media reports before the announcement, the outcome was marginally better than anticipated.
The good news
- The overall impact of Trump’s proposed tariff is limited from a purely economic perspective. Research by Bank of America Merrill Lynch and CLSA estimates a net impact of c. US$5-6bn, taking into account tariff levels imposed and price elasticity. This compares with total Chinese exports of US$2.3trillion and is inconsequential when measured against the size of the Chinese economy at US$12.3tr.
- China’s response in terms of reciprocal tariffs has so far been considered and measured. Immediately following the US Presidential announcement, the Chinese Embassy in the US issued a statement, stating categorically that ‘’China does not want a trade war with anyone’’. Shortly after, trade measures on US exports totalling c. US$3bn of products including seamless steel pipes, pork and recycled aluminium were announced by China’s Ministry of Commerce. Global equity markets reacted positively, suggesting the scale of China’s intended proposal was smaller and far less damaging than initially feared.
- Despite the exchange of tariff threats, there is still a window of opportunity in which both parties can negotiate and seek a more agreeable outcome. Recall that the USTR detailed list is not published until April 6, following which the public will be given a month to review and comment. Reports that US Treasury Secretary Mnuchin is negotiating with China has provided some degree of reassurance to investors.
- Should upcoming US mid-term elections be a strong factor in President Trump’s decision to initiate the US trade war on China, a victory through extracting negotiated concessions as opposed to an all-out trade war will do no harm to his campaign and should be the preferred outcome.
And possibly some bad
While the argument for waxing and waning can be made, the risk of US-China tensions escalating further between two countries competing for global supremacy and lasting longer than the majority of investors expect cannot be ruled out.
The US attitude towards China has turned decisively more confrontational in recent times, reflecting the view that Trump views China as a strategic adversary. Negotiations may stall or worse, collapse, leading to the imposition of various alternative economic and political tools to gain a perceived upper hand. These may include, but are not limited to, fines, the cancelling of existing free trade agreements, anti-trust investigations and the boycotting of products.
Historical precedents do not lend themselves well to a positive outcome. The US/Japan trade conflict, involving imposed quotas of imported Japanese cars in 1980s, lasted the best part of an entire decade despite Japan being a strategic ally to the US. In terms of US posturing, The Economist compares the current threat posed by China as far bigger than the combined military and ideological threat posed by the Soviet Union during the Cold War and the threat posed by Japan’s technological prowess in the 1980s.
During periods of heightened market stress, elevated volatility and political tension, we do not want to be making short-term forecasts. Rather, we rely on the high level of rigour and discipline that underpins our quantitative decision making framework to allocate capital and manage risk in China. Our China market model seeks to provide timely buy and sell signals, on balance, through cycles.
With the return of volatility and accompanying choppy markets, the model has been busier than usual. We received a fresh ‘sell’ signal last week. Our stock selection model seeks to identify and invest in what we perceive to be the top 20% most attractive companies in the MSCI China universe at the point of investment. As of now, the model favours domestically focused, cyclically geared China exposure.
The Chindia Equity Fund implemented a protection strategy in the form of HSCEI (Hang Seng China Enterprises Index) put options and VIX (Volatility Index) call options in early February and remains in place.
The objective is to dampen short-term volatility and/or the prospect of further downside returns in a manner which is cost-effective and can provide value to our clients. We are also holding c.8% cash which we anticipate deploying into stocks at more attractive levels.